Lam Research CFO: Great Industry, Great Company, Cheap Stock

Following the analyst day meeting yesterday of chip equipment maker Lam Research (LRCX), Chief Financial Officer Doug Bettinger was kind enough to brave the snow and sleet to visit Barron’s offices.

His overall message was that the chip industry is a great industry, Lam is a great company, and its shares, at a recent price of $210.02, are undervalued. The stock trades at 15.7 times trailing 12-month earnings per share. The forward multiple, based on this fiscal year’s estimated $16.66 per share, is only 12.6 times.

Getting Beyond the Cycle

To explain why things are so good, Bettinger this year tried something different at the meeting.

As the discussion on Wall Street about semiconductors, and semi-equipment, tends to be dominated by talk of the semiconductor “cycle,” the swings of investment that have at times produced boom-and-bust financials, he found a way to minimize the “amplitude” of that discussion.

What if, he suggested to his audience, spending on equipment out in 2021 is the same as it is this year, so no industry growth?

That would nevertheless produce earnings per share of $23 to $25 for Lam, well above the estimate furthest out at this point, $17.79 for fiscal 2020.

That forecast was doubtless a surprise to many at the meeting yesterday, and Lam shares rose almost 5% for the day and are up another 1% today despite wobbly markets.

"This gets us out of the debate about the cycle,” he said, “and focuses the discussion on the things we can control."

The Business Levers

Those things are garnering a greater share of the revenue its products cover. Lam “addressed” 28% of the total spending, known as “wafer fabrication equipment,” or WFE, in 2014, he notes, and that was 36% last year. By 2021, he thinks the company can address over 40% of the relevant industry spend. At the same time, Lam is taking share in its two main product categories, “deposition” and “etch,” he notes.

Combined, that means returns can be increasingly good even with a flat market. Of course, he thinks spending can be higher in 2021, but it’s an intellectual exercise that helps frame the discussion.

And there’s a third element: A quarter of Lam’s annual revenue comes from its services business, where it gets paid to maintain equipment, for example, and where it buys back used equipment, refurbishes it, and turns around and sells it as “certified pre-owned,” rather like a used-car business. The incremental profit dollars in that business can be higher-margin than the other 75%.

Lam doesn’t break out such services revenue, and Bettinger only offers it anecdotally. Still, he says, “It’s my favorite part of the business.”

"I will talk for an hour at one of these meetings, and then I’ll say, ‘You haven’t asked me about 25% or our business!’ "

An Empire Built on Reuse

Why does he like it? “It’s an annuity,” in the sense that it keeps expanding as the equipment stays around and gets reused. “In the decades following an initial equipment sale, the profit potential can be as much as the initial sale,” says Bettinger.

And there are plenty of reasons for reuse. For example, as many others have pointed out, things such as the Internet of Things don’t necessarily use the latest cutting-edge gear. They can often be done in older chip feature sizes, what are known as “process nodes.” Intel’s (INTC) latest and greatest might be built using dimensions as small as 7 billions of a meter. But an IoT part could be made by Taiwan Semiconductor Manufacturing (TSM), the world’s largest contract chip maker, in equipment that produces parts of a quarter of a micron, or 250 billionths of a meter.

Lam is finding new ways to build that services business. It has started offering what it calls “advanced services,” such as “chamber matching,” making sure that parts are kept uniform from machine to machine.

But, but, a Skeptic Will Interrupt, No Cycle? Really?!

"I would never tell you there is not a cycle,” says Bettinger. “But the amplitude is reduced,” so that the ups and downs, the booms and the busts, are not as treacherous as in years past. Reasons include consolidation—Lam bought Novellus in 2012, giving it the deposition part of its portfolio that it has married well to its traditional focus on etch. Another deal, to buy competitor KLA-Tencor (KLAC), was nixed in 2016 by regulators, a matter about which he shrugs and smiles at this point.

“This industry is in a great spot,” he says. One stat: Spending on equipment is at a 15-year low as a percentage of profits, even though spending keeps going up. So much money is being made, the economics are terrific for the chip makers.

At the moment, and for the foreseeable future, he implies, “demand is driving things.” The includes a vast expansion in the need for silicon for autonomous vehicles, A.I., the Internet of Things, etc., etc.

Thanks for the Memory

Lam has been particularly lucky in being at the epicenter of the explosion in memory chips. “We are better positioned than anyone in the chip equipment industry,” he tells me, given that memory will likely continue to be especially valuable, relative to logic chips.

“Memory is the place to be, right?"

“To feed a GPU [graphics processing unit], that data needs to be processed in memory,” he notes. “It’s all about storage and memory circuits,” he concludes. “And what’s exciting for us is, all of it has aspects of that 3-D device structure,” meaning a departure in recent years from traditional chip formation that has brought enormous technical challenges in manufacturing. “That’s all about building up some stuff, and then carving away some stuff, which is all deposition and etch.”

Memory will continue to take an increasing role, he believes, and “the lines will blur between memory and logic,” he offers. “Just look at things like neuromorphic computing."

If after all that skeptics still insist on contemplating an eventual decline in equipment spending, Bettinger offered another thought experiment yesterday. He asked his audience to imagine if total WFE spend went to $40 billion for the year, below last year’s $47 billion. (He actually thinks it will rise a few percent this year.)

In a $40 billion market, the company could make the same profit it made last year, via these drivers of increasing relevance and increasing share, and services.

“If you think WFE is $40 billion, and it happens in 2019 or 2020, or whatever, our earnings power will largely look like what it did in 2017."

“This is your way to be satisfied in the event of a downturn."

The Payoff

All of which leads to yesterday’s announcement of increased capital returns: a more-than-doubling of the dividend, come June, from its current 50 cents to $1.10 per share per quarter, or $4.40 annually, or a 2% yield; plus another $2 billion in buybacks on top of an existing $2 billion authorization.

Prompting that was the U.S. tax reform, which is freeing up $6 billion in overseas cash, and taking a look at what competitors are doing. He concedes Lam has some tough competitors among tech firms paying out.

“Some investors have said to me, we would like to have seen more,” he confesses. “This is a big step forward for us,” with perhaps more to come in future. Asked about the company’s balance sheet, he notes the company will end up with less net cash than before tax reform. He’s “not comfortable yet” going to a zero cash balance, as some companies such as Apple (AAPL) are contemplating.

But he also didn’t rule it out, saying the overall strategy with things like that is “emerging” for Lam.

With a 50% payout of free cash flow now—the first time the company has put that stake in the ground—he’s hoping more value and income investors will be drawn to the stock.

“It’s about supply and demand,” he says, meaning supply of stock and investor demand. “We hope this opens up demand."

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Lam Research CFO: Great Industry, Great Company, Cheap Stock

Following the analyst day meeting yesterday of chip equipment maker Lam Research (LRCX), Chief Financial Officer Doug Bettinger was kind enough to brave the snow and sleet to visit Barron’s offices.

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